Expectations of Limited

Transcription

1 Summer The Newsletter of the BDO private equity practice Did you know... According to Dow Jones LP Source, in the first quarter of 2012 U.S. private equity funds raised $38.1 billion for 136 funds a 4 percent increase in capital raised and a 5 percent increase in fund closings from the first quarter of Small-cap deals ($250 million or less) constituted 82 percent of the transactions in the first quarter, says Preqin, up four percentage points from 2011 s fourth quarter. Deals are smaller and, instead of making big bets on platform companies, PE firms are acquiring bolt-on firms to integrate with existing portfolio companies. An Inside Look at the Expectations of Limited Partners in a Post-Great Recession World Q&A with Scott Paladini, founder of Twelve Peers Consulting By Jerry Dentinger, Partner in the Transaction Advisory Services practice, and Michael Kuczborski, Partner in the Private Equity practice, at BDO 1. What are LPs currently looking for in GPs? What new, tough questions should GPs expect to receive from LPs in the wake of the Great Recession? raising capital in a post-great Recession world is a difficult task. LPs have become less willing to allocate funds to new managers and current managers are under increased scrutiny as to how they generate returns. When evaluating a fund, one of the key areas that LPs focus on is the operating experience of GPs. Prior to 2008, financial engineering and creative finance could help generate returns, but that is no longer the case. Today, LPs are very concerned about a GP s operational experience they want proof that a team can roll up its sleeves, get involved in the company and truly add value. GPs should be prepared to extensively explain their operating expertise and experience. I also believe that increased transparency at both the fund and portfolio company According to the third annual BDO PErspective Private Equity Study, one fifth (22 percent) of private equity fund managers regardless of fund size expect to deploy $30 million to $50 million of capital through new deals and add-on acquisitions in 2012 and another 16 percent expect to invest $51 million to $100 million. The private equity industry has grown tremendously over the past 30 years. In 1981, there were 23 private equity firms. In 2011, there were more than 4,000. In the past 10 years alone, private equity assets under management have grown from approximately $750 billion in December 2001 to almost $3 trillion in December 2011, according to data compiled by The Deal Pipeline. Private equity investors have boosted spending on pipeline mergers and acquisitions. Private equity firms were involved in $4.4 billion worth of deals for oil- and gas-gathering lines and processing plants in North America last year, a 63 percent increase from $2.7 billion in 2010, according to data compiled by Bloomberg. Among the 100 tech CFOs polled in the 2012 BDO Technology Outlook Survey, 35 percent plan to use private equity as a means of raising capital, down from 43 percent in Another 9 percent will turn to public equity. Read more on page 2

2 2 BDO PErspective Continued from page 1 Limited Partners in a Post-Great Recession World level is becoming a standard request from LPs. They want to have a better understanding of the underlying investments and the expected cash flows, and a more standardized process for reporting that information. Finally, I think that LPs are currently feeling more comfortable with larger, more established funds that are playing in both the middle-market and $1 billion+ deal space versus the smaller middle-market funds that could struggle with deal flow and lack the operational resources of larger funds. 2. What geographies and sectors are growing and attractive to LPs? The emerging markets continue to be a hot area for investment. I don t think you can speak to an LP that hasn t already invested, or isn t currently looking to invest, in China. The same can be said for Brazil, which has really taken off in the past couple of years especially as the U.S. and European markets have struggled. That said, there is good money to be made in the U.S. Private debt and distressed funds are enjoying a lot of success, and will continue to be areas of growth for LPs. I also believe the secondary market will have strong years in 2012 and 2013 as LPs look for liquidity, given the lack of distributions over the past couple of years. In Europe, the current environment is high risk/high reward. While many LPs are steering clear of Europe, those who do enter the region could end up reaping very significant rewards if the situation starts to improve and they back GPs with the expertise to navigate those markets. 3. How will the capital overhang affect fundraising in 2012? There has been a lot of discussion about the capital overhang affecting fundraising in 2012, but as I see it, a lot of that overhang will start to go away as GPs aggressively look to put money to work. An important factor that has not been discussed very much is the fact that 2007 vintage funds are reaching their five-year investment period is already proving to be a big deal year with 20 percent more deals than last year. As the second half approaches, I believe activity will pick up even more. A strong deal environment, coupled with a rise in the stock market, has once again started to balance out LPs portfolio allocations and I believe this will result in an uptick in private equity capital raising as compared to Yet, it will also be as competitive as ever with so many funds currently competing for capital. With this in mind, GPs should try to take advantage of the European LP market, where many LPs are under-allocated in their PE portfolios and looking to move money away from Europe and into more attractive markets. 4. How will the capital overhang affect fees, fee structures and reporting transparency for new funds raised? lps have more leverage in their negotiations for better fees and terms following the Great Recession and the lackluster private equity market over the past couple of years. I definitely see fee pressure, especially on management fees, with LPs pushing 1.5 percent management fees on non-first quartile funds becoming more the norm. Yet, LPs are willing to pay for performance with a 20 percent performance fee above a preferred return still being standard. LPs also want to see greater transparency in the reporting of fund performance and I think that Dodd- Frank will have a very interesting impact on LP due diligence and GP transparency over the next year. With GPs required to provide an enormous amount of information on their funds and firms with the filing of Form PF, I can envision LPs requesting that information as well much of which traditionally hasn t been shared. However, I expect GPs to seek to maintain higher management fees in order to help fund the cost of increased reporting and transparency. Overall, LPs will put the most pressure on smaller, mid-market and first-time funds that will have a harder time raising capital and have less leverage in negotiating terms. 5. In the wake of the Great Recession, are funds including structures in their new funds to make the terms more attractive to LPs? GPs are very aware of the current market and creating fund terms that are unique and attractive to LPs is one way for them to stay one step ahead. For example, the Carlyle Group included a liquidity provision in its sixth fund. I think this is a very creative option that, on the surface, appears to be a very LP-friendly term. That said, it will be interesting to see it actually tested. GPs will definitely need to think more like LPs in order to compete for funds. They will need to ask themselves, Would I want this as an investor? All of those special terms and conditions will start to creep into LPAs as funds try to distinguish themselves and raise money. 6. Nearly one-fourth of respondents to BDO s third annual PErspective Private Equity Study identified the quantity of PE funds raising new funds as the most significant fundraising challenge they have faced in the past year. With so many funds currently seeking capital, how can funds differentiate themselves in the eyes of LPs? Obviously, track record is at the top of the list and that is always going to be critical. Read more on page 3

3 BDO PErspective 3 Continued from page 2 Limited Partners That said, there are a number of things funds can do to distinguish themselves beyond track record. First, the right team is crucial. It s important to have a diversified mix of financial and operating professionals, as well as a history of working together. For example, a group that spins out of another fund will be more attractive than a team that is just put together Estate and Gift Tax Planning Opportunities for the Private Equity Professional By Ed Smith, Tax Partner in the Private Equity practice at BDO Second, high-quality, proprietary deal flow is necessary. Going to an LP with tangible deals on the table and a strong pipeline will be better received than showing up with only a strategy and a plan for cultivating deals. On top of this, offering attractive co-investment opportunities will be looked at favorably. More and more LPs are getting involved in direct investment and co-investment, and those GPs that make co-investment readily available stand to gain. Third, it s important to focus on the little things that make a difference, i.e., keep fund expenses down, provide greater transparency to investors, offer creative structures and establish good governance with a strong LP advisory board. All of these little things can add up and make the difference between winning and losing. Overall, make the LP feel like a real partner that you want a long lasting relationship with and not just a limited partner. Scott Paladini is the founder of Twelve Peers Consulting, which specializes in growing private equity firms by supporting the marketing, capital raising and deal sourcing efforts that are critical to attracting outside capital investment. Since 2010, Twelve Peers Consulting has helped raise more than $1.5 billion in capital for private equity and direct sponsor clients. Twelve Peers Consulting also co-invests in select direct investment opportunities and made its first capital commitment in February For more information please contact Jerry Dentinger, Partner in BDO s Transaction Advisory practice at jdentinger@bdo.com, or Michael Kuczborski, Partner in BDO s Private Equity practice at mkuczborski@bdo.com. On June 7, 2001, President George Bush signed into law the Economic Growth and Tax Relief Reconciliation Act of 2001, which was designed to phase out the federal estate and gift tax over a 10-year period, such that there was no estate and gift tax in Since the 2001 Act had a 10-year term, upon expiration on Dec. 31, 2010, the estate and gift tax law would revert to the 2000 law, which provided for an estate and gift tax lifetime exclusion of $1 million and maximum rate of 55 percent. On Dec. 17, 2010, President Barack Obama signed the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act, which provided for a $5 million estate and gift tax exemption and a maximum rate of 35 percent for 2011 and If Congress does not extend the current act or pass new legislation, after 2012, the estate and gift tax law will again revert to the $1 million estate and gift tax exemption and a 55 percent maximum rate under the 2000 law. There is substantial uncertainty as to whether Congress will pass a new estate and gift tax law or extend the current provisions beyond Therefore, a limited window exists to take advantage of the $5 million exemption ($5,120,000 in 2012) and 35 percent maximum rate under the 2010 Act estate and gift tax provisions. Since the gift tax exemption mirrors the estate tax exemption, it is now possible to make gifts during 2012 up to the remaining gift and estate tax exemption without incurring a gift tax in the process. Making gifts of income producing and/or appreciating property will shift the income and appreciation to recipients of the gifts, resulting in future estate tax savings. Private equity professionals are in a unique position to take advantage of the current opportunities for estate tax planning savings. As investors and principals of private equity funds, private equity professionals can transfer a portion of their interests in the private equity funds to their children, subject to the provisions of the funds. If gifts of non-marketable securities are made, the fair market value of the gift must be determined. The Internal Revenue Service Read more on page 4

4 4 BDO PErspective Continued from page Estate and Gift Tax Planning will allow discounts for lack of marketability and lack of control/minority interest in determining the fair market value of nonpublicly traded securities. Discounts typically can range from 15 percent to 40 percent, depending on facts and circumstances. This, in effect, leverages up the gross value of the gifts of non-marketable securities that can be made and offset by the $5 million exemption ($5,120,000 in 2012). If the interest in the private equity fund can be given at inception or during the early stage of the fund, this is an extremely effective use of the estate and gift tax exclusion. If the private equity professional is required by the fund documents to maintain voting control or does not wish for the children to execute control over their interest in the fund, the gift can be made to a family limited partnership or a family trust. A family limited partnership can be formed with the private equity professional as the general partner (or managing member if a limited liability company is formed) giving that professional voting control over the fund interest owned by the partnership. In the alternative, a trust can be formed for the benefit of the children and be the recipient of the gifted fund interest. The trustee would exercise the voting power over the fund interest. If the trust is formed granting the trustees discretionary powers as to distributions, generally states would treat the partnership interest held by the trust as beyond the reach of creditors of the beneficiaries. Creditor protection offered to beneficiaries of trusts varies by state with some states, such as Delaware, being very liberal and providing creditor protection in some cases for self-settled trusts. A grantor retained annuity trust (GRAT) can also be used to leverage the value of the gift tax exemption. Under a GRAT structure, the donor transfers an asset to a trust and retains the right to an annuity payment. To the extent that the value of the asset transferred to the trust exceeds the value of the annuity payments to be received, the donor has made a taxable gift. Under current tax law the GRAT can be structured more or less, if appropriate, to zero out the taxable gift. A zeroed out GRAT would not use any gift tax exemption and yet, still offers the opportunity to shift appreciation to the next generation. Further, a sale to a grantor trust (IDGT) can be used where a grantor makes a gift of assets to the trust and then sells additional assets to the trust in return for a promissory note over a term of years, with interest at the IRC Section 7520 rate (1.08 percent for March 2012). The IDGT receives the income from the asset and pays interest annually. At the end of the term of the note, the balance on the note is repaid in cash or by transferring a portion of the asset back to the donor. Similar to the zeroed out GRAT, this planning strategy can be designed to use none of the gift tax exemption and still transfer future appreciation to subsequent generations. The sale to the IDGT is more flexible than the GRAT, when you wish to benefit grandchildren because the generation skipping exemption can be allocated to the IDGT at the commencement of the trust. Under the GRAT and IDGT structures, the trust retains the appreciation and current income, in excess of the annual annuity or interest payments during the term of the trust. In addition, the federal and state income tax on the income earned by the trust is paid by the grantor, thereby not reducing the trust s assets further. For private equity professionals, these opportunities, when coupled together, result in the following estate and gift tax benefits, if gifts of fund interests are made: 1) Moving appreciation by gifts in the early stages of fund formation 2) valuation discounts due to the nonmarketable structure of private equity funds 3) Moving additional appreciation and income through the use of GRAT and IDGT structures, with limited use of the gift tax exemption To take advantage of these opportunities, private equity professionals should consult their tax advisors and counsel. For more information please contact Ed Smith, Tax partner in BDO s Private Equity practice at ejsmith@bdo.com.

5 BDO PErspective 5 General Partner Compensation: Under Pressure but Holding Strong By Lee Duran, Assurance Partner in the Private Equity practice and Scott Hendon, Tax Partner in the Private Equity practice, at BDO Savvy investors know that they get what they pay for. Currently, many private equity funds are facing significant difficulties in raising new capital while, at the same time, experiencing increased pressure to reduce management fees. However, many limited partners (LPs) are still showing flexibility in compensating general partners ( GPs ) for their value-added management services and providing performance-based incentives tied to the risks associated with portfolio performance. Compensation paid to GPs comes in a number of forms including management fees, carried interests, transaction fees and monitoring or advisory fees: Management fees are typically between 1.5 percent and 2.5 percent of committed capital. The fees provide the working capital for fund operations and are taxed as ordinary income. Carried interests are performance-based fees and are typically 20 percent of net profits after LPs receive a preferred, compounded annual return that usually ranges from 8 percent to 10 percent per annum. In some cases, however, PE funds offer a graduated fee based on the level of the preferred return, e.g., 15 percent after a 6 percent preferred return, 20 percent after an 8 percent preferred return, etc. If structured properly, carried interests are an allocation of long-term capital gains for tax purposes that have favorable tax rates for individuals. There is proposed legislation to tax carried interest at ordinary income rates, but to date, none of the proposed legislation has been passed by Congress. Transaction fees are commonly charged by PE funds but not venture capital funds, and are typically 1 percent of the gross transaction amount. Monitoring or advisory fees are smaller, fixed fees charged on a monthly basis to portfolio companies and retained by GPs. Of these forms of compensation, management fees are the most visible and, as a result, many PE funds are reducing up-front management fees but retaining other compensation and fees, particularly carried interests. With regard to other changes funds are making to their compensation structures, we are seeing the following: Most GPs are reducing the management fee after the fund is fully deployed by decreasing it incrementally over time from 2 percent to 0.5 percent, for example. Others are deferring some or all of the management fees after the deployment period in exchange for additional carried interests. While this is a common strategy, it may create certain tax risks resulting in income being characterized as ordinary income rather than long-term capital gains. It also shifts economic risk from LPs to GPs. larger funds have more flexibility with management fees given their large asset base and, therefore, have been more inclined to apply a discount to these fees. Smaller funds, however, have not discounted management fees, keeping them near the 2 percent benchmark. Of course, as they search for qualified investments in the early stage of a fund s cycle, GPs need the working capital provided by management fees to aid in their efforts. A handful of GPs are providing lines of credit until capital is called. The line earns a reasonable return on the capital for GPs and helps LPs by deferring some of the capital call; only rarely will this impact the management fee base amount. Some LPs have tried to set management fees as a percentage of deployed capital rather than of committed capital; however, fund sponsors are unlikely to accept this calculation base. GPs value-add lies in their ability to find quality investments that will pay off over time. Changing the management fee calculation to provide an artificial incentive to deploy capital may result in GPs closing deals faster than is prudent, resulting in reduced returns in the long term. lp preferred returns, which usually average between 8 percent to 10 percent prior to carry calculations, are declining, with many new limited partnership agreements coming in at 6 percent to 8 percent preferred returns. There has been little change in the way GPs and LPs calculate profit and loss split and carry percentages. GPs carry continues to be set at approximately 20 percent. As we found in our third annual PErspective Private Equity Study, in today s environment, investment exits are often delayed by a year or even two as GPs wait for the right opportunity to emerge and maximize the return on their investment. This extended holding period ties up investor capital and potentially puts pressure on LPs internal rate of return. Delayed liquidity events also increase the threshold, before which carried interests are earned by GPs. Given the current fundraising environment, we re seeing GPs take on significant risks, and provide valuable time and money to sourcing and managing deals. And these efforts are resulting in greater fund success. So, while many LPs have been negotiating fees and terms following the Great Recession, we believe that GPs overall compensation will and should hold strong. As Professor D. T. Robinson of Duke University stated in a study published in June 2011 GPs with higher compensation generate higher gross performance, i.e., investors do, indeed, get what they pay for. For more information please contact Lee Duran, Assurance partner and leader of BDO s Private Equity practice at lduran@bdo.com, or Scott Hendon, Tax partner in BDO s Private Equity practice at shendon@bdo.com.

6 6 BDO PErspective 2012 Private Equity Event Schedule Contact: The following is a list of upcoming conferences and seminars from the leading private equity associations and business bureaus: April April PERE Global Investor Forum The Intercontinental Los Angeles, Calif. April ACG Intergrowth Gaylord Texan Hotel Dallas, Texas Stop by BDO s booth (#567) to meet the Private Equity team! May May IFC s Global Private Equity Conference Ritz-Carlton Washington, D.C. May Dow Jones Private Equity Analyst Limited Partners Summit Grand Hyatt New York, N.Y. June June IBF Venture Capital Investing Conference TBA San Francisco, Calif. June 10 PEI Responsible Investment Forum Grosvenor House London, UK Wayne Corini, Washington, D.C / wcorini@bdo.com Scott Cacurak, San Francisco / scacurak@bdo.com Alfredo Cepero, Miami / acepero@bdo.com Jerry Dentinger, Chicago / jdentinger@bdo.com Lee Duran, San Diego / lduran@bdo.com Ryan Guthrie, Costa Mesa / rguthrie@bdo.com Scott Hendon, Dallas / shendon@bdo.com Mike Kuczborski, Philadelphia / mkuczborski@bdo.com Matt Segal, Chicago / msegal@bdo.com BDO Private Equity Practice Strategically focused and remarkably responsive, the experienced, multidisciplinary partners and directors of BDO s Private Equity practice provide value-added assurance, tax and consulting services for all aspects of a fund s cycle, wherever private equity firms are investing. About BDO BDO is the brand name for BDO USA, LLP, a U.S. professional services firm providing assurance, tax, financial advisory and consulting services to a wide range of publicly traded and privately held companies. For more than 100 years, BDO has provided quality service through the active involvement of experienced and committed professionals. The firm serves clients through more than 40 offices and more than 400 independent alliance firm locations nationwide. As an independent Member Firm of BDO International Limited, BDO serves multinational clients through a global network of 1,118 offices in 135 countries. BDO USA, LLP, a Delaware limited liability partnership, is the U.S. member of BDO International Limited, a UK company limited by guarantee, and forms part of the international BDO network of independent member firms. BDO is the brand name for the BDO network and for each of the BDO Member Firms. For more information, please visit: Material discussed is meant to provide general information and should not be acted upon without first obtaining professional advice appropriately tailored to your individual circumstances. To ensure compliance with Treasury Department regulations, we wish to inform you that any tax advice that may be contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding tax-related penalties under the Internal Revenue Code or applicable state or local tax or (ii) promoting, marketing or recommending to another party any tax-related matters addressed herein BDO USA, LLP. All rights reserved.